EU Nations to Recalculate GDP Using Underground Markets

LOS ANGELES—Some European nations are changing the way they estimate the size of their economies by including revenue from underground markets including prostitution, smuggling and drugs when determining their gross domestic product. The move has raised some eyebrows regarding the accuracy of the revenue that will be counted as well as unintended consequences that may ensue from using them to calculate GDP.

Bloomberg reported last month that "Italy will include prostitution and illegal drug sales in the gross domestic product calculation this year, a boost for its chronically stagnant economy and Prime Minister Matteo Renzi’s effort to meet deficit targets.

"Drugs, prostitution and smuggling," it added, "will be part of GDP as of 2014, and prior-year figures will be adjusted to reflect the change in methodology, the Istat national statistics office said today. The revision was made to comply with European Union rules."

The move to include so-called illicit sales in estimates about gross domestic product is not limited to Italy. The Wall Street Journalreported a few days ago that the United Kingdom and Ireland are doing the same thing, though we would ask the same question of them as we would of the Italians: How exactly are you getting your numbers about the amount of illicit sales? Who precisely is informing you about the scale and profitability of operations, and are you sure you can believe them?

In Italy, we presume, drugs, smuggling and prostitution are mostly under the control of the mafia. How, we wonder, could those markets be estimated with any accuracy without the mafia working glove-in-hand with government economists in order to tally the take for the purposes of GDP? But we're less clear about how that mechanism will likely work in other countries. As absurd as the notion is, will drug cartels and smugglers of contraband be asked to submit quarterly reports?

We particularly wondered how they will get a handle on revenue derived from prostitution. In the U.K., the WSJ explains how it is expected to work, "For prostitutes," it reports, "the statisticians will begin with an estimated tally of on-street prostitutes from the London Metropolitan Police and an estimate of off-street prostitutes from a nongovernment group that studies violence against women and girls. The number of prostitutes will be assumed to rise or fall along with the male population. The assumed cost of prostitution services will fluctuate along with the prices of lap dances and escort agencies, 'the closest activities we have to prostitution' that are already measured." The mentioned barometers fail to include online activities like live camming, however, which generate increasing revenue around the world.

The methodology for drugs is similarly myopic. "The U.K.'s Office for National Statistics says it will estimate consumption of six drugs: crack cocaine, powder cocaine, heroin, cannabis, ecstasy and amphetamines," reports the WSJ. "Officials will first calculate the number of drug users based on crime surveys, and then multiply by an estimate of the average amount of drugs consumed per user.

"Then, a series of estimates will hold the accounts in balance," it continues. "For example, to avoid distorting the statistics on imports, the percentage of cannabis that is homegrown must be estimated. Then, an assumption is made about the volume of seeds and amount of electricity used in production."

Assumptions are common in financial estimates, but there is often a mechanism used that can ascertain after the fact if the original estimates were accurate or not, and make the necessary adjustments. But that will be more difficult to do in this scenario, which is a concern to some.

According to Claus Vistesen, chief euro-zone economist for Pantheon Macroeconomics, there is "a trade-off between taking in as much information as you can, and accuracy." The plan to incorporate underground economies into the larger economy could, he said, end up making GDP measures "less accurate."

On the other hand, the WSJ reasons in its piece, "If drug sales aren't counted in a place where people spend half their income on drugs, one could conclude, wrongly, that the population saved half its money."

Indeed, while that is a rational argument, it also seems clear that employing a system in which a nation can basically create its own numbers for underground economies that normally react to sunlight like vampires or cockroaches allows for an unprecedented level of wriggle room when it comes to squaring the books and putting together a new national budget.

The problem with that, says Thomas Costerg, an economist for U.K.-based bank Standard Chartered, "is you can get very theoretical and there could be some side effects, including the rising skepticism of statistics in the general population."

The size of the anticipated readjustment indicate the scale of the potential fallout. Per the WSJ, "The U.K. could add as much as $9 billion to the value of its GDP by including prostitution and about $7.4 billion by adding illegal drugs, by one estimate, enough to boost the size of its economy by 0.7%."

But the increase could be smaller. The same article also notes, "The overall changes from adding illicit activity may prove small, as that is just one component of the statistical revisions sweeping Europe. The U.K., for example, has altered how it will measure nonprofit groups, a shift that will boost its GDP more than the drugs and prostitution, and capital formation and inventories, which will shrink its GDP."

Look for some fluctuation in the numbers coming out of these countries for the next few years, and also for other countries to jump on board the underground economy counting bandwagon as they endeavor to keep up with the Jonses across the border.